Value Lifelines in a Crisis

In the last sections we examined how oversold the financial stocks became in that crisis. While not of the same magnitude, we saw in chapter 10 how cheap the pharmaceutical stocks became as investors lost confidence in their futures in 1993/1994. The common denominator in all crises is a sharp drop in prices fostered by a serious investor overreaction, whether on a major scale as occurred with financial stocks, or on a somewhat reduced level as was the case with pharmaceuticals. It is precisely this large drop, often in the order of 50% or more, that allows you to set up the lifeline I spoke of in die previous section. You can apply a systematic set of value lifelines to an investor overreaction and measure how far prices have deviated from their normal levels.

Table I2-2a shows the normal P/E, price-to-book value, and dividend relationships for bank stocks one year before the crisis, at its crisis low point, and one year after the crisis. Look at the price-to-book ratio. It falls from 1.6 to .9 at the bottom of the crisis. In effect you have a fire sale with the price of the merchandise chopped to about half the level it was at only a year or two before. Note too that the price-to-book ratio increased dramatically over the next year, from 0.9 to 1.6. The higher price-to-book ratio indicates the stocks have almost doubled from their 1990 lows.*

Another good indicator is dividend yield. In Table I2-2a you can see how sharply it has risen at the bottom of the crisis from its more normal level one year earlier. Yields more than doubled from die year before the crisis to its height, moving up from 4.1% in the second quarter of 1989 to an astonishing 8.8% at the height in the third quarter of 1990. They then fall back to 3.9% one year later. Though the dividend rates on bank stocks have shown an impressive rate of increase during this period, prices have risen even more rapidly, more than doubling for the industry as a whole-not a bad reason for a substantially reduced dividend yield.

* By late 1997 banks were being acquired at prices as high as 4-and in the case of Bar-nett Banks, 5-times book value.

crisis-producing situations, are one example of such training. Because trauma is both repetitive and costly in the marlcetplace, the introduction of training of this sort, at least on an experimental basis, would seem beneficial.

The major lifeline in a crisis is that fundamental values increase dramatically in your favor because of rapidly falling stock prices. Whereas before the panic you got a dividend yield of 4.1 % on the average bank, you now get 8.8%. Where the banks in the S&P 500 previously traded at 1.6 times book value, they now trade at half of this ratio-and this after deducting large write-offs for bad loans.*

Now look at Figure 12-1, which shows the price performance of bank stocks in the S&P 500 (25 banks) compared to the performance of the S&P itself. As the chart makes obvious, investing in a crisis pays off handsomely. What perhaps is not so obvious is that banks continued to outperform the S&P 500 for years after the crisis ended, including a 195% spurt from 1995 to the end of 1997. Why is this so?

Part of the reason is that banks have been a low P/E industry for years. The crisis just made them that much cheaper. Even when their multiples were restored to more normal levels, they still traded at a substantial discount to die S&P 500 by almost all of the contrarian indicators. The banking crisis allowed the value shopper to buy bargain merchandise at a fraction of the going rate.

Look now at Table 12-2b, which shows the investment fundamentals before, during, and after the crisis in pharmaceutical stocks from the first quarter of 1993 to early 1995. Once again note the substantial drop in the contrarian indicators, P/E, price to book, and yield, at the bottom of the crisis. The indicators are much higher than for banks, because pharmaceuticals are normally a high multiple industry. Nevertheless die pattems are the same.

Price-to-book value, for example, falls from 10.0 before the crisis to 5.5, while yield expands from 2.0% before to 3.7% at the height of the crisis. Finally P/E drops from 26.0 before to 16.5 at the peak of the over-reaction, even though many dmg companies took substantial one-time

* Price/earnings is not a good indicator in this case, because many of the bank stocks are reporting only marginal earnings or losses, making this ratio unrealistic.

Table 12-2a

Precrisis, Crisis, and Postcrisis Fundamentals-Banks Stocks

Figure 12-1

Crisis Price Performance

S&P 500, Banks, and Drug Stocks

3

&

-5 2

1990

1991

1992

1993

1994

1995

1996

1997

Banks

- - - Drugs

-S&P

write-offs at diis time, increasing the P/E ratios at the bottom.* Also note how price-to-book value and price-to-earnings rose and yield dropped one year later, indicating die dramatic bounce-back in prices. This is shown in Figure 12-1, which demonstrates how handdy the pharmaceuticals whipped the rapidly rising S&P 500 from the bottom of the crisis.

Finally, lets examine from a value standpoint the opportunity available in the bond crisis of 1982, discussed briefly in the last chapter. In this case the most important value yardstick is yield after inflation for a nontaxable account, or yield after taxes and inflation for a taxable account. At the height of the panic on long bonds, 30-year Treasuries were yielding over 15%. This yield could be guaranteed by buying zero-coupon bonds (securities that pay no interest but instead are sold at discounts large enough to include the interest rate over the life of the bond.) Municipal bonds yielded as high as 15%. Municipal bonds, of course, are exempt from Federal income taxes.

* For some peculiar reason-possibly that Hillary C. was looking disapprovingly at their large profits.